The story presented in much of the UK media is simple and intuitive. The previous government messed up: they spent too much, and it left the UK economy on the brink of financial meltdown. The coalition came to the rescue: clearing up the mess was tough at first, but now it is all coming good.

AIn previous posts I have shown that this is almost complete fiction. The increase in the government’s budget deficit under Labour was all about the recession, which in turn was created by the global financial crisis. There was no prospect of a UK financial crisis in 2010, which meant that austerity was not something the government was forced to undertake. Reducing the deficit could have been left until the recovery was secure (and crucially interest rates had risen above their lower bound), but the coalition chose to do otherwise. As a result they delayed the recovery by three years, at great cost. Even since 2013 we have simply seen a return to normal growth rates: there has been no catching up of lost ground. In that sense growth under the coalition hardly deserves the term recovery, and we have seen an unprecedented lack of growth in living standards. Productivity growth has been non-existent, yet the government has feted the employment growth that is its counterpart.

Here it is perhaps easiest to talk about monetary policy as putting money into the system when inflation is too low or taking it out when inflation is too high. QE creates money when interest rates are at their Zero Lower Bound (ZLB), but that money can be taken out of the system later if need be by selling the assets that QE buys. Helicopter money also puts money into the system at the ZLB, in a much more effective way than QE, but it cannot be put into reverse by central banks alone. The central bank cannot demand we pay helicopter money back.

If the government cooperates, this is no problem. The government just ‘recapitalises’ the central bank, by either raising taxes or selling more of its own debt. Economists call this ‘fiscal backing’ for the central bank. In either case, the government is taking money out of the system on the central bank’s behalf. So the nightmare that makes helicopter money taboo is that the government refuses to do this.

What kind of government would this be? Inflation is rising, and the institution tasked with bringing it back under control makes a request that can be satisfied fairly painlessly by the government issuing some more debt. A government that refuses to do this is saying very publicly that it no longer cares about high inflation: it prefers an environment of low interest rates and high inflation and it is prepared to cripple its central bank to achieve this.

Now imagine a government with these preferences, and now put it in a world where the ICB does not need recapitalising and is selling assets and raising interest rates to do its job. Are we really meant to believe that such a government would ignore its preferences and let the central bank get on with it? Of course it would not – it would take away the central bank’s independence by forcing it to stop raising interest rates.

In other words, a government that would refuse to recapitalise an ICB is also a government that would have no hesitation in ending central bank independence. Holding assets is no protection for an ICB against this government of its nightmares. [2]

The reason we have independent central banks is not to stop us becoming like Zimbabwe. It is to stop governments taking small risks with inflation for short term political gain. Like the occasion I was told that the Chancellor (at the time) knew full well that interest rates needed to rise now to reduce inflation, but there was no way that would happen until after the party conference. But this kind of government is not the kind that would deliberately sabotage its own central bank by refusing a request for recapitalisation.

There are plenty of example where the European Union (EU) requires some serious political consensus: the EU requires partial transfers of sovereignty to a supranational authority when it comes to legislation, the EU has economic mechanisms that imply a significant transfer of income across countries (via its budget, the structural and cohesion funds). Then why is it that the EU does not require to be backed by a political union in the same way the Euro project does?

(…)

The euro facilitated flows across countries as exchange rate risks had disappeared and provided the illusion of no risk. Second, once the flows had taken place it created financial links between banks and governments across countries that made them exposed to the same risk. In addition, the ECB because its connections with banks became a central repository of that risk and a solution for some of the countries facing a credit crunch — the ECB acted like the IMF in many ways.

None of this is exactly about monetary policy, even if the ECB is involved. This is about financial risk and how financial crises have painful economic consequences. When sharing a currency the risk of financial crisis and its potential solutions bring countries and governments together in a way that a political consensus seems to be necessary because transfers might be involved and because common political solutions need to be found. And while these transfers might be smaller than the ones agreed as part of the Social and Cohesion Funds of the European Union, they come as a surprise and they are uncertain (we cannot agree ex-ante on their final size). This is what makes the Euro project a much more difficult one to manage without a sense that we all belong to the same group and are willing to work on this together.

For many, the Euro was one of the projects within the much bigger ambition behind the European Union (which came with the idea of a partial political union). But the recent financial crisis has shown that the risks associated to sharing a currency when financial and sovereign crises are possible, are a lot larger than what we thought. And these risks are much larger than the risks associated to simply sharing the same currency and the same monetary policy (yes, one interest rate does not fit all but this is not the real issue this time).

2009 was the peak underlying primary deficit, and it was huge, representing the actions of a truly profligate government. However what followed was complete cold turkey: within two years the underlying primary balance was close to zero. A pretty conservative estimate for the impact of fiscal consolidation would reduce GDP by 1% for each 1% of GDP reduction in the primary balance. In those terms, all of the current output gap in Greece can be explained by austerity.

As I have always said, some period involving a negative output gap was inevitable because Greece had to regain the competitiveness it lost as a result of the previous boom fuelled by fiscal profligacy. But slow gradual adjustment is more efficient than cold turkey. Paul Krugman explains one reason for this: resistance to nominal wage cuts. But there is another which is even more conventional. If we have a Phillips curve where inflation expectations are endogenous (either through rational or adaptive expectations) rather than anchored to some inflation target (as Paul implicitly assumes), then competitiveness adjustment can be achieved with a much lower cost in terms of the cumulated output gap if it is done slowly. (I gave an example here, then reacting to the idea that Latvia’s cold turkey adjustment had been a success.)

There are only two serious barriers to this more efficient adjustment path. The first is the willingness of some outside body to provide the loans to fund the gradual reduction in the government’s deficit. The second is getting those outside bodies to recognise this basic macro: austerity hits output, and gradual adjustment is better. I think the second turned out to be the crucial problem with Greece: as has been extensively documented, the Troika were hopelessly optimistic about the impact cold turkey would have.

The problem with the second argument is twofold. First, it tunes in with the popular sentiment in Germany that the country is yet again being asked to ‘bail out’ its Eurozone neighbours. Second, it implicitly suggests that the current German macroeconomic position is appropriate, but that Germany must move away from this position for the sake of the Eurozone as a whole. The obvious German response is to list all the reasons why their economy is currently on track (see, for example, Otmar Issing in the FT recently), and suggest therefore that other countries should look at their own policies for salvation. This is how we end up needlessly discussing structural reforms in France, Italy and so on.

The uncomfortable truth for Germany, which both the previous arguments can miss, is that the appropriate macroeconomic position for Germany at the moment is a boom, with inflation running well above 2%. The current competitiveness misalignment is a result of low nominal wage growth in Germany over the 2000 to 2007 period, which was in effect (and perhaps unintentionally) a beggar my neighbour policy with respect to the rest of the Eurozone. Germany’s current position is unsustainable, as its huge current account surplus and relative cyclical position shows. It will be corrected by undoing what happened from 2000 to 2007. Over the next five or ten years, German inflation will exceed the Eurozone average until its long term relative competitive position is restored.

The only choice is how this happens. From the perspective of the Eurozone as a whole, the efficient solution would be above 2% inflation in Germany, and below 2% inflation elsewhere. That is what would happen if the ECB was able to do its job, and Germany would get no choice in the matter. Normally above 2% inflation in Germany would require a boom (a positive output gap), but if it can be achieved without that fine, although I would note that current German inflation is only 0.8%. Arguments that point to currently low unemployment and a zero output gap in Germany are therefore irrelevant while German inflation is so low. The inefficient alternative solution is for 2% or less inflation in Germany, and actual or near deflation outside. Why is this solution inefficient? Because to get inflation that low outside Germany requires the Eurozone recession we are now experiencing

This is where structural reforms enter. Many German commentators say ‘why cannot other countries do what we did from 2000 to 2007’? But low nominal wage growth in Germany from 2000 to 2007 was accompanied by a recession in Germany! Furthermore, that recession was not so bad as the current Eurozone position, because the ECB was able to do its job and cut interest rates, so inflation outside Germany was above 2%. So from 2000 to 2007 many countries had to experience above target inflation because of low nominal wage growth in Germany, [2] yet many in Germany want to avoid above target inflation while imbalances are corrected.

If your starting point is what happened in Germany from 2000 to 2007, then current German arguments can look incredibly self-centred. They seem to say: we suffered a recession from 2000 to 2007 which led to a beggar my neighbour outcome, now you have to suffer a worse recession to put right the problem we created. But as I have argued before, and which comments on my recent posts and readings confirm, I think the German position is more about ignorance than greed. I also suspect there is a great deal of macroeconomic ignorance outside Germany as well, which is why Germany has been able to impose a recession on the rest of the Eurozone. Take for example this paper by Michael Miebach, who speaks from the left of centre in Germany.

Miebach presents a wide range of macroeconomic fallacies or irrelevant arguments. Germany’s fiscal position is not good (irrelevant in a liquidity trap), its macroeconomic position is not too bad (when it should have above 2% inflation, which probably requires a boom), fiscal expansion in Germany would have only a small impact on the periphery (but what we should be talking about is fiscal expansion in all the main Eurozone economies, which this paper confirms would help the periphery as well as France, Italy etc, and expansion in Germany would benefit countries like the Netherlands), and the old canard about how focusing on demand distracts attention from dealing with structural weaknesses in the Eurozone. But most revealingly we have this.

Quite a few people — including a lot of people on Wall Street, at the BIS, and so on — look at this and say that it’s terrible: the Fed is keeping interest rates “artificially low” and thereby distorting asset prices across the board, and it will all end in grief.

But although I hear the phrase “artificially low” all the time, I don’t think many people who use it have thought through what they mean. What would a non-artificial interest rate be?

Well, we do know from Wicksell what an unnatural rate, which sounds like more or less the same thing, would be: it would be an interest rate set too low in the sense that the economy overheats and we have accelerating inflation. But that hasn’t been happening; yes, there’s a slight uptick in some U.S. inflation measures, but nothing out there that suggests an interest rate that is way too low in this macroeconomic sense.

So what are the people complaining about artificially low rates talking about? Partly that they’re low by historical standards — but there are enough changes in the landscape, from deleveraging to demography, that this isn’t a convincing argument. But the main thing, I think, is those asset prices, which the advocates of tight money think are too high — because they wouldn’t make sense without those “artificially low” interest rates.

In case you haven’t noticed, this is a completely circular argument. Once you accept the possibility that rates belong where they are, or even a bit lower, to correspond to the Wicksellian natural rate, you also conclude that asset prices might make sense; and once you concede that asset prices might make sense, you lose the supposed evidence that rates are all wrong.

And one more thing: where is the wild exuberance that we associate with dangerous bubbles? I don’t see popular TV shows about house-flipping, and CNBC viewership is plumbing new lows.

Mainly, though, there simply isn’t any macroeconomic case for claiming that interest rates are wildly depressed relative to fundamentals, and not much reason to believe that assets in general are overvalued.

The old (but, historically, still ‘post’) Keynesian, IS/LM account of deficient demand, pretty much resembles the more modern account embedded in the rational expectations, sticky price models, dubbed ‘new’ Keynesian. But using these models to prescribe drastic fiscal expansions that greatly exceeded what we saw is problematic. In the UK, inflation exceeded target substantially. In the US, it has not fallen all that much below it. Modifications of the New Keynesian model that have a financial sector explain the recession as a dramatic constriction in credit supply that both strangles output, and creates inflationary pressure (offsetting the depressing effect on inflation coming from the fall in demand).

Following this line of argument, conventional demand-side fiscal policy was roughly on track. You might argue that we ought to have had very great deviations of above target inflation, and much looser conventional fiscal policy. But to do this you would have to ditch what those models say about the costs of inflation. They contain the view that inflation fluctuations are an order of magnitude more costly than fluctuations in real activity. So much the worse for them, you might say. And policy makers frequently have said this. But, with the models thus binned, you are in the dark about what should be done. And there’s no way you can then argue that economics gives a clear answer, since you have discarded the one bottom-to-top [microfounded] answer it does give. Granted, not everyone goes in for bottom-to-topness. But that just reinforces my point that there is no sound economic answer.

Things are obviously worse than this, because the models that Paul Krugman is using to reason his way to arguing for a drastic further fiscal stimulus don’t contain financial sectors. And the ones that get bolted onto the New Keynesian models to argue that policy was about right contain financial sectors that aren’t subject to systemic runs; don’t malfunction therefore in the way that the real one did.

One of the themes of the early post crisis debate was the controversy between those like the Tory-led Coalition in the UK who warned about the possibility of a run on UK sovereign bonds, and those like PK who dismissed these concerns as opportunistic invoking of the ‘bond market fairy’.

PK would have history judge that he made the right call on this. Certainly there were no runs on UK or US bonds. But economics itself could not have given such an unambiguous a steer as PK claims. The literature on optimal fiscal policy is riddled with ambiguity. How to view what government does: wasteful, substituting, complementing private expenditure? How to model the possibility of runs, and on what they might depend? Whether to accept the possibility of the fiscal theory of the price level. [And whether this should be viewed as a difficulty or, as Sims sometimes suggested, an opportunity]. How to account for why people hold money. [Without a good account of that, we can’t confidently say how they will price nominal bonds]. Whether the government can be viewed as being able to commit; if not, whether it can acquire a reputation for good behaviour. [If they can commit, then borrow now pay later strategies will work better]. Whether prices are sticky or not. [This affects how much work fiscal policy should do to stabilise]. How to assess the tensions in the intergenerational conflicts over fiscal policy. [Another take on the commitment problem]. How to produce normative guidelines for good fiscal policy that weighs concerns of competing generations. The imponderable questions regarding how policy should deal with uncertainty, applied to the task of designing fiscal policy. [How to weigh the unknown risks of a sovereign run, versus a deflationary spiral, for example].

I don’t know what economics PK has read. But the miserably small quantity of serious reading I have managed on the above issues leaves me thinking that economics does not offer the clear advice PK claims. PK seems to be backing away from all these intractable debates about the detail, and saying that we can ignore it. Big picture, demand was weak, public demand had to be stronger. Politicians did not get this message clearly enough, and were able to ignore it. End of story. Well, maybe. Maybe not. Perhaps only great minds can see the wood for all these unfinished modelling trees. But to me it looks like a mess that many decades of future research may not sort out.

I think a plausible account of public policy failure is that our economics profession had not yet come up with clear answers. And in the absence of this politicians were free (or perhaps had no choice but) to be guided by their baser political imperatives.